BYPASS TRUST: Examples and How It Works

Bypass Trust

A bypass trust is an irrevocable trust into which the settlor deposits assets and which is intended to pay trust income and principal to the settlor’s spouse for the duration of the spouse’s life in the United States. The transfer of the settlor’s assets to the bypass trust for the benefit of the spouse is a tax-free transfer under the Marital Deduction, which is currently unlimited. The assets in the bypass trust are not included in the settlor’s estate at the settlor’s death, effectively reducing the total value of the estate and potentially limiting the estate taxes owed at the settlor’s death. In this blog post, we will discuss what a bypass trust is, capital gains bypass trust, an example of a bypass trust, bypass trust distribution rules, and what happens if a bypass trust is never funded.

In the United States, bypass trusts are used as a legal tool to avoid gift tax and reduce the taxation of assets upon the death of a married couple.

What is a Bypass Trust

A bypass trust is a tool for long-term planning. It is typically established as part of an A/B Living trust estate plan following the death of the first spouse. A married couple transfers property ownership into a trust during their lifetime. The terms of the trust require that some of the property be transferred into “TRUST A” and some other portion into “TRUST B” upon the death of the first party to die.

Trust A holds property that is accessible to the surviving spouse for the rest of his or her life. That way, the surviving spouse will have enough money to cover his or her needs until death.

Trust B receives the remainder of the original trust’s property in a tax-efficient manner, preventing the surviving spouse from accessing it during his or her lifetime. This trust is intended to pass property to heirs, typically the spouse’s children, upon the death of the remaining spouse, but in a way that minimizes the estate and gift taxes that would have been applied to the property if it had passed through a will or if given as a gift during life.

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The bypass trust is typically established to accomplish one or more of the following objectives:

  • To make the best use of the decedent’s estate tax exclusion amount in order to pay the least amount of estate tax upon the death of the surviving spouse.
  • To ensure that the property of the decedent’s spouse is disposed of in accordance with the decedent’s wishes; even if the surviving spouse remarries or chooses to use a different estate plan for the surviving spouse’s assets.

Why Would You Use a Bypass Trust?

For married couples with substantial assets, a bypass trust can reduce the federal (and state) estate tax. Assets up to an annual exemption limit are not subject to federal estate tax with the family or B portion of the trust. The limit for 2019 is $11.4 million, which doubles to $22.8 million for married couples. If the assets in the family trust do not exceed that amount, they are not subject to the federal estate tax.

The surviving spouse’s assets in a marital trust are not subject to federal or state estate tax. The surviving spouse can also provide his or her heirs with tax and credit shelter benefits. Secondary trusts can hold assets that will be passed down to heirs such as children or grandchildren.

Capital Gains Bypass Trust

A Capital Gains Bypass Trust, also known as a charitable remainder trust (CRT), is a trust that allows you to keep more of your money by donating it.

By establishing a Capital Gains Bypass Trust, you can place appreciated assets in the trust and receive a charitable deduction to offset the income taxes you owe in the year the trust is established. The trust can then sell the appreciated property without having to pay capital gains taxes on the profit. As a result, the total amount reinvested is the sales price. The trust can be set up so that the income generated by its assets is distributed to you or anyone else you choose. When you die, whatever remains in the trust must be distributed to the charity you have designated.
Capital Gains Bypass Trust will provide you with the following advantages:

  • Bypass taxes on capital gains
  • Boost your retirement income
  • Boost your tax deductions
  • Reduce your IRS taxable estate.
  • Contribute to charitable organizations.

By combining a capital gains bypass trust with a family foundation and a tax-free inheritance trust; you can eliminate capital gains, increase your income for life, increase an income stream for your children’s lives; dramatically reduce your estate taxes, and create a 100 percent tax-free inheritance for your children.

Consequences of Taxation

When you choose a Capital Gains Bypass Trust, you can often create a significant current income tax deduction; that can be carried forward for up to 5 years. When trust assets are invested, the resulting income is almost always greater than; it would have been prior to the transfer. This is due to the fact that the typical asset given to a Capital Gains Bypass Trust is a portfolio of stocks, mutual funds; raw land, or similar assets with a low-cost basis that are typically low-income producers. Following the tax-free sale of these highly appreciated but low-income-producing assets, the resulting portfolio can be invested in higher-income-producing assets under the direction and control of the trust maker acting as trustee.

What are the Procedures?

To begin, you must calculate your tax deduction, capital gains savings, and level of income from the use of a Capital Gains Bypass Trust. If the structure is advantageous to you, you will transfer appreciated property (stocks, bonds, and real estate) into the trust. As the trustee, you will retain control of the trust. Because of its charitable nature, the trust may then sell the appreciated property and pay no capital gains on the sale. Because of the tax-free sale, you will have more money to invest and a larger stream of income as the income beneficiary of the trust. Upon your and your spouse’s deaths, any funds remaining in the trust will be distributed to a charitable organization. This “charitable organization” could be your personal foundation.

Bypass Trust Example

Let’s look at an example of a bypass trust below:

Assume a couple with $1.8 million in assets in 2000. Their husband died, and his will left $1.0 million to the bypass trust for the benefit of his wife. The trust terms state that

  1. she is entitled to all income
  2. she is entitled to distributions for her health, education, and support; and
  3. a trustee may distribute all trust assets to her for any purpose, even if the trust is depleted.

The purpose of this trust was to protect the first million dollars of the estate from estate taxes; when the surviving spouse died later, but it also gave the trustee the authority to make unlimited distributions to the spouse.

Assume that in the intervening years, the wife has protected her own $800,000 from the cost of long-term care by putting it in an Irrevocable Trust. Meanwhile, the bypass trust fund has grown to $1.6 million. There are two major issues to address: capital gains tax and the cost of long-term care.

The assets in the surviving spouse’s irrevocable trust will be counted as part of her taxable estate when she dies. If she dies this year, her state estate tax exemption will be $5.93 million in 2021; her federal exemption will be $11.7 million. She clearly does not have a taxable estate. Her assets will be passed down to the next generation tax-free. The assets in the bypass trust, on the other hand, will be subject to capital gains tax for any growth in principle. Assuming a $600,000 capital gain and a capital gain rate of 33%, the capital gains tax could be just under $200,000.

There would be no estate tax and no capital gains tax if the bypass trust assets were not in the trust but in the estate of the surviving spouse. In this case, assuming no other facts, it may be best to distribute the assets to the surviving spouse and allow the assets to benefit from a “step-up in basis” upon her death.

The second issue with the bypass trust is that the trust’s broad distribution rights make trust assets available to pay for the spouse’s long-term care. She has safeguarded her own assets, but the $1.6 million is likely to be spent down. If the trustee distributed the trust assets to the surviving spouse in this case; she could add those assets to her Irrevocable Grantor trust. She would benefit from the trust’s income and her estate would receive a step-up in basis upon her death. Also, the assets would be protected from the cost of nursing home care or catastrophic illness after five years.

You should be able to tell how it works and when it will be used from the preceding bypass trust example.

Bypass Trust Distribution Rules

A bypass trust receives assets in accordance with the terms of the trust document. This could be half or all of the deceased spouse’s property; it could also be just enough property to ensure that the deceased spouse’s tax exclusion is fully utilized. The IRS specifies the specific text to be used for each trust, which should be written in great detail. Cash, a house, investments, life insurance policies, businesses, valuable art; antiques, and gems could all be included in the A trust’s assets. Consult with an estate planning attorney.

What if a Bypass Trust Is Never Funded?

The IRS may levy penalties, taxes, and interest if you fail to fund the bypass trust or do so late. This is unfortunate, especially given that the bypass trust is no longer required for estate tax minimization. It provides a procedure for changing such a trust even after the death of the first spouse.

Is It Possible for a Bypass Trust to be Valid if It Is Not Funded?

An unfunded trust, on the other hand, is not null and void. Unfunded revocable trusts, for example, will remain valid but inactive until they are funded. It will not be able to carry out its intended function unless it receives funding. It is true, however, that some trusts must wait for specific events before they can be funded.

How Is a Bypass Trust Funded?

Typically, the bypass trust is funded with the deceased spouse’s separate property and one-half interest in the couple’s community property, or it may only be funded up to the deceased spouse’s unused estate tax exclusion amount, with the remainder funded to the A trust.

Is It Possible to Terminate a Bypass Trust?

Because the bypass trust is irrevocable, the surviving spouse cannot change, amend, or terminate it. While a bypass trust can allow income and principal distributions to the surviving spouse; the amount that can be distributed is severely limited depending on how the trust is drafted.

What Does “Fully Funded” Mean in the Context of a Trust?

Funding an RLT is accomplished by changing the ownership of assets; so that they are owned by the RLT’s trustee rather than the RLT’s individual creator. “Fully” funding an RLT means transferring all, or nearly all, of the assets that can be transferred to it.

Conclusion

The role of a bypass trust in your estate plan is largely determined by the value of your estate. It also depends on how much estate tax you want your heirs or spouse to pay after you die. If the estate tax exemptions are reduced, you may require a bypass trust. A bypass trust, on the other hand; maybe less useful if you don’t have as many assets to leave to your spouse.

Bypass Trust FAQs

What is the benefit of a bypass trust?

This property is also exempt from estate tax because everything left to a surviving spouse is exempt from federal (and state) estate tax. The tax savings will be realized upon the death of the second spouse. The property in the bypass trust will then pass tax-free to the couple’s “final beneficiaries,” who are usually their children.

Who owns a bypass trust?

A bypass trust, also known as an AB trust or credit shelter trust, is a married couple’s estate planning strategy that can help them reduce or avoid federal estate tax. When one of the spouses dies, their assets are divided between two trusts known as the A trust and the B trust.

What should be included in a bypass trust?

Bypass trust provisions allow a married couple to use the estate tax exemption in both spouses’ estates rather than just the surviving spouse’s estate. For example, David and Martha, two American citizens with $4,000,000 in assets, sign simple wills that leave everything to the surviving spouse.

How are bypass trusts taxed?

The undistributed income of a bypass trust (income not distributed to beneficiaries) is taxed at compressed trust income tax rates, which subject any undistributed income over $12,750 (2021) to the top marginal income tax rate of 37% and potentially to the additional 3.8 percent Medicare surtax on net investment.

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